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Using ETFs to invest in currencies

Previous to currency linked ETFs becoming available, investing in those markets for retail investors was as difficult as with commodities. The only route for individual investors was through expensive and leveraged commodity and futures pools. Currency trading was the domain for large banks and other institutions accustomed to dealing with large sums daily in the inter-bank market.

Why are currency linked ETFs important? In the first place they’re necessary for hedging purposes. For example, in 2013 the Nikkei 225 Index in Japan gained nearly 59 percent, but Japan ETF [EWJ] gained 27 percent. While a respectable return for the ETF, naturally an investor would like the return of the index more. The difference was the value of the yen, which had deteriorated by an equal amount. If an investor would have shorted FXY in an appropriate amount to hedge yen currency risks, they would have realized the full return of the local index. Alternatively, an investor could have invested in a currency hedged equity fund, [DXJ]. Currency hedged equity funds use forward contracts to hedge out local currency exposure, essentially allowing them to own the underlying equity in USD terms.

This does bring up the issue of risk associated with currency linked ETFs, especially leveraged and inverse ETFs, and that is of volatile markets, rapidly fluctuating exchange rates, and the high cost of hedging.

Anything that threatens the stability or effectiveness of the government can have an instant impact on the currency. Political events generally trigger a stronger reaction in the currencies of emerging market countries, where political institutions are more fragile, but even in the most developed countries in the world like the United States and the United Kingdom, less serious political problems can still hurt the currency.

When it comes to the financial markets, staying on top of the big stories is a critical part of becoming a good trader or investor. Newsworthy events such as the UK referendum to exit the Eurozone can have a major impact on the general sentiment of the market and the demand for a country’s currency. These are the triggers for the 10 to 15 percent moves in currencies. The events that can have a profound impact on the value of a currency include but are not limited to the following:

Potential or actual changes in government

Economic crisis

Major announcements by finance ministers and central bankers after G20 meetings

Intervention by central banks

Strikes and riots

Wars and terrorism

Natural disasters

Decisions made by government officials

Political and social developments will affect many different financial instruments, but intervention by central banks is unique to the forex market. When a currency becomes excessively strong or weak, the central bank may feel compelled to intervene directly in the foreign exchange market to change the currency’s course. The reason is that the value of a country’s currency can have a direct impact on the economy and the competitiveness of local companies. Central banks usually start with verbal intervention, which are threats to intervene and stop the currency from rising or falling—sometimes it works, but often it doesn’t. Actions speak much louder than words and therefore physical intervention is much more potent. Central banks physically intervene in the foreign exchange market by buying or selling their currency. The reason intervention is so important is that, on a given day, a currency pair typically moves 100 pips throughout the day but when central banks intervene, the currency can move anywhere from 150 to 300 pips in a matter of minutes. As a result, traders take intervention by central banks very seriously because it can shake out their positions. Sometimes it will even mark the top or bottom for a currency, but usually fundamentals (or the reason for the previous move) eventually catch up to the currency and it resumes its prior trend.

Overall, currency products make up a small portion of the ETF universe. Even as the asset class has expanded to 35 available products in 14 categories, approximately 85% of the assets sit in 25% of the available funds. You can see the details of where the assets are in Figure 1.

Figure 1: Currency ETF Assets: Combining Assets of Various Structures with Similar Exposures

Source: Bloomberg. As of 6/21/16.

Structure of Currency Products

The first currency products came to the market in 2005 in the grantor trust structure, and the ETF structure was not launched into the marketplace until 2008. The currency ETFs are issued as registered investment companies (RICs) and are registered under the Investment Company Act of 1940. However, grantor trusts and ETNs are not registered under the 1940 Act.

As registered investment companies, these funds have added flexibility in managing their underlying investments to shape their risk-return profiles. These funds have the protections characteristic of funds structured as registered investment companies, including:

Diversified credit risk

Limitations on leverage and lending

Oversight of a board of directors

Assets that are segregated and maintained with a qualified custodian

It is interesting to note that the currency ETFs came to the market under the actively managed fund exemption because they are not tracking indexes even though they are attempting to provide reasonably passive exposure to currency movements and non-U.S. money market rates. The benefits to this active management exemption are mostly in operational efficiency within the structure. Given their flexibility, the funds can alter their investment approach in delivering the desired exposure to shareholders. The FX markets are among the most liquid in the world, but access to locally denominated money market instruments and spot exchange rates differs between various regions. In a few developed markets, the currency ETFs take a direct approach, as they invest directly into locally denominated money market investments.1 As can be seen in Table 1, this is a distinctive structural feature available for taxable investors in ETFs versus the earlier grantor trust products.

Table 1: Characteristics of currency fund structures

Currency Exchange-Traded Fund

Currency Grantor Trust

Currency Exchange Traded Note

Sructure

Actively managed registered investment company (RIC)

Unmanaged trust

Unsecured debt instrument issued by bank

Underlying investments

Investments in money market securities; some use forward currency contracts

Foreign bank deposits

No underlying holdings

Distribution policy

Variable

Variable

Variable

Income Distribution

If distributed, taxed at ordinary income tax rates

Taxed at ordinary income tax rates, even if no distribution

If distributed, taxed at ordinary tax rates

Year-End Gain Distributions

Realized gains on security sales (minimal expectations); realized and unrealized gains on derivatives (taxable in part as ordinary income)

Limited, potential foreign exchange (FX) gains

None

Sales

Gains taxed as capital gains; long-term capital gains tax rates if held for more than a year. Ordinary income tax rates if held for less than a year

Gains taxed at ordinary income tax rates

Gains attributable to currency fluctuations and accrued interest built into note likely to be taxed at ordinary income tax rates

Source: WisdomTree Asset Management

Only a few countries have local money markets with the combination of issuer breadth, development, and accessibility necessary for this direct approach to structuring funds. The currency ETFs providing exposure to less accessible markets utilize currency forward contracts combined with U.S. cash-type investments to manage and achieve their exposures. This combination produces a risk-return profile that is economically similar to that of a locally denominated money market instrument. In nearly all of the markets for which the ETFs use this approach, trading volume in FX is high enough to support product growth. Because of the liquidity of the underlying portfolios, which combine emerging market currencies with U.S. cash-type products, these ETFs typically feature bid-ask spreads narrower than many credit-specific fixed-income ETFs. Similar to the fixed-income markets, however, the currency markets are not accustomed to trading in the small size typical of newly launched ETFs.

Currently there are three main types of currency products available: ETFs, grantor trusts, and exchange-traded notes (ETNs). I mention several times that structure is going to be the new battleground where products compete with similar exposures. Nowhere is this more apparent than in the currency products landscape. A look at some of the characteristics of the various currency structures available is shown in Table 1.

Nuances of the Currency Markets

Currencies trade 24 hours a day, but the volume in particular currencies is typically concentrated around the local market hours and trading times at the nearest of the three main trading hubs: Asia (Tokyo, Singapore, and Hong Kong), Europe (London), and the Americas (New York). Although futures exist on many currencies, the bulk of FX transactions occur in the over-the-counter interbank markets through spot transactions, forward transactions, and swaps. Tullett Prebon Group Inc., ICAP, and the WM Company provide commonly followed fixing times, but nearly every broker-dealer also provides fixing prices at other designated times. Real-time quotes are generally available via Bloomberg and Reuters data services. For example, Bloomberg produces real-time composite quotes, while Tullett Prebon Group and others have real-time feeds for contracts on currencies available via Reuters and Bloomberg. The less liquid and less accessible the currency, the greater will be the variability in pricing. The general point is the fact that the currency market is an over-the-counter marketplace with varying times of liquidity and accessibility. The ETP issuer has the challenge of defining an Intraday Indicative Value and creating an investment strategy using the currency and money market instruments to best serve the end investor.

Article copyright 2011 by David J. Abner, David H. Fry, and Kathy Lien. Reprinted and adapted from The ETF Handbook: How to Value and Trade Exchange Traded Funds, Create Your Own ETF Hedge Fund: A Do-It-Yourself ETF Strategy for Private Wealth Management, and The Little Book of Currency Trading: How to Make Big Profits in the World of Forex with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.

The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Currency ETPs are generally more volatile than broad-based ETFs and can be affected by various factors which may include changes in national debt levels and trade deficits, domestic and foreign inflation rates, domestic and foreign interest rates, and global or regional political, regulatory, economic or financial events. ETPs that track a single currency or exchange rate may exhibit even greater volatility. Currency ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the performance of the referenced currency or exchange rate, particularly over longer holding periods.

ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments. ETFs are subject to management fees and other expenses.

1. Currency ETFs are not "money market" funds and do not seek to maintain a constant share price.

Currency ETPs are generally more volatile than broad-based ETFs and can be affected by various factors, which may include changes in national debt levels and trade deficits; domestic and foreign inflation rates; domestic and foreign interest rates; and global or regional political, regulatory, economic, or financial events. ETPs that track a single currency or exchange rate may exhibit even greater volatility. Currency ETPs that use futures, options, or other derivative instruments may involve still greater risk, and performance can deviate significantly from the performance of the referenced currency or exchange rate, particularly over longer holding periods.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Institutional investors, banks, and hedge funds traditionally dominated the currency markets. With the advent of ETFs, individual investors now have the ability to gain exposure to this large and tremendously important asset class.